The subject of pyramid scheme is well known and you might think, that you don’t need to write about it anymore. However, I don’t think so. There are several reasons. First of all, you need to know the very mechanism of their functioning in order not to lose your money. It’s clear. Secondly, new forms of pyramid schemes will surely appear. History shows, that they look a bit different every time, but they always bring a risk to your money. Importantly, their functioning uses your emotions, primarily based on greed, and this can always get you into trouble. So, beware on pyramid scheme.
Definition of danger
At the beginning I will use the definition like here:
Pyramid Scheme – a financial structure, in which the profit of a specific participant is directly dependent on the contributions of subsequent participants, standing somewhat lower in this structure. After Charles Ponzi, the creator of the first ever pyramid scheme, this structure is also known as the “Ponzi scheme”. The pyramid schemes are designed to attract as many participants as possible with the promise of high returns, that feed the pyramid scheme. Initially, the founders look for the first participants, then the participants look for more victims.
As mentioned in the definition, the scheme was first used by Charles Ponzi, who in 1920 in Boston cheated the participants of the firs pyramid scheme for then (and now also) exorbitant amount of 15 million dollars. The most famous pyramid schemes of recent times is the pyramid scheme created by Bernard Madoff, which resulted in the loss of investors at the level of about 35 billion dollars. Interestingly and importantly, Madoff created it despite the existence of “anti-pyramidal” legislation. He died in prison.
What is a pyramid scheme scheme
But to the point. Pyramid schemes are inherently doomed to collapse, when the inflow of new participants and the inflow of new capital ceases. The number of participants is inherently limited. As the pyramid produces nothing, it does not provide services, it only uses the capital of its participants. It can be said, that pyramid schemes are created ONLY to deceive their participants – by the founders.
Often, pyramid schemes are associated with MLM (Multi-Level-Marketing) and affiliate marketing. This is a mistake. There are many honest MLM companies. It is often noted, that pyramid schemes do not create anything, even if they give the impression, that they are investing in gold, the stock market, real estate, etc.
How does it work?
The scheme of working of the pyramid scheme is always similar. It’s based on a similar model, although it usually looks a bit different each time (people usually don’t fall for the same trick in a short period of time). Let’s imagine, that a person (it can be a few people or a company) proposes a great deposit, e.g. 20% per year. It makes an impression (about B. Madoff proposed ONLY 12.5% annual rate of return but sure…). The founders advertise it as a brilliant investment, because the managers use new, sensational (?) investment methods. The condition for participation in this investment is the need to invest at least, for example, 100 EUR (the amount is indicated only to show the mechanism in detail). Limited access is also a certain incentive. Of course, the founder of the pyramids must have a certain amount of capital at the beginning.
Let’s assume at the very beginning the founder has gained 3 “investors” and each of them will pay 100 EUR. At the beginning, the amounts paid into the pyramid are small. Of course, participans are not aware at first, that this is a pyramid scheme.
It is known, that at the beginning no one believes in this brilliant way of investing – after all, no one can PROVIDE a constant rate of return of 20% per annum. The owner of the pyramid holds 300 EUR. A small amount. After a year, the founder of the pyramid must, of course, “give back” to each investor or prove, that they earned 20 EUR (for each 100 EUR). A year passes and that’s what happens. Suppose all investors receive 120 EUR each and withdraw their money. This is where the game based on emotions begins.
Investors get their input and profit, they are more trusting (that’s what the founder is counting on). The owner of the pyramid provides information, that you can invest further. Investors who have already earned, invest again, but this time for 200 EUR. More, but they have already earned. Their trust grows. At the same time, what is important, they pass information about their ingenious way of investing to their friends. At the beginning, they do not believe either and at the beginning 2 of them also invest 100 EUR at the beginning.
In addition, the owner of the pyramid proposes, that for each new “investor” they bring and who pays 100 EUR, they will receive 10 EUR per year. The pyramid grows, new investors appear, “connected” to the already existing ones.
For the founder, slowly the situation starts to change. Slowly, over time, payments to subsequent investors are made not from the founder’s capital, but from the capital of the new entrants to the pyramid. The name pyramid comes from the shape of the structure – those at the bottom, who are the most, finance the higher levels participans.
The pyramid grows. The first, “oldest” investors receive profits. They are more and more satisfied. The news spreads more and more among more and more people. There are other investors who are not so cautious anymore. The pyramid grows until there are no new investors … the payments from which will pay out more “profits” for existing investors. When they are missing, the whole system collapse.
How it works in reality (emotional side)
How the pyramid scheme works in reality. I can write this from my own autopsy, because I participated in such a scheme. I will not give its name because I do not know what its legal status is. But to the point. The pyramid grows, new participants join. Most importantly, the level of trust of new, new investors is growing. Faith in the skills of the leader of the pyramid (or his managers) is growing. While new investors invest relatively small amounts, the “old” investors lose their common sense and start injecting really large amounts into the pyramid, hoping for a big and easy profit.
When there is a shortage of new participants and capital to pay out the “profits”, the pyramid begins to fall. The result is usually the loss of capital by investors, it happens that the founders disappear with the capital. This situation is especially difficult for investors who have multiplied their investments. Unfortunately, they often lose their capital then. The pyramid bares its structure – the catastrophe becomes public overnight.
Why you should know the scheme of the pyramid scheme
Of course, this article is not an instruction, but a warning. This is important because, as I wrote at the beginning, such schemes of action appear all the time in the world. They look a bit different each time, have a different form, and are dressed in different products. Financial supervision authority publishes on its websites warnings against entities that may be pyramid scheme (just look in the browser).
How to recognize a pyramid scheme
It is not a simple and straightforward operation. The following activities can be distinguished:
- First, check the headquarters of the running company. If it is registered in a tax haven, it should be the first red light.
- High, CERTAIN profits in relation to what the market offers. For example, 5 times higher profits, than on a bank deposit should be another red light.
- A well-created and run website is no determinant.
- Beware of the impressions of elitism created by such an undertaking. Usually it can only be appearances.
- You probably won’t find negative comments about such a structure (after all, it still exists and gives great “profit” to investors). You will only get positive information about how easy it is to earn money, there are no problems with withdrawing money, etc. etc.
- Check the submitted annual report in the National Court Register of the running entity. If he has an obligation to do so, and he hasn’t, it is suspicious.
- If the contact with the company is only electronic or via the Internet, it is also another red signal.
And summing up
As I mentioned, there is no clear way to identify a pyramid scheme. Search for information, learn about their functioning. You will avoid trouble and loss of property.
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